Penalty clauses in an IT service contract: Extracting the most

It's easy to put penalty clauses in a service contract, but difficult to exercise them. These tips will help you get the most out of your penalty clauses.

It's not common to see service providers pay you for their mistakes. In some cases, the steps taken to compensate...

for losses due to downtime are not comparable to the incurred losses. So can it be assumed that service providers have the upper hand while drafting penalty clauses? Is the business always set to lose in such arrangements? These pointers to penalty clause design should be of assistance on this front.

More on vendor management:
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The cover-up: Never give a free rein to people drafting penalty clauses. Also many service providers may not agree to penalty clauses in the contract, due to their companies' longstanding policies.

In businesses such as Evalueserve, we are heavily dependent on external service providers — be it application service providers or internet service providers. If these vendors don't work with our team, business losses can be quite high. But if we impose very stringent penalty clauses to counter such situations, our vendors may not agree.

It goes without saying that service providers agree only to penalty clauses favourable to them. At times, we have also failed while trying to negotiate the penalty clauses' figures. There are times when you end up agreeing with the service provider's terms.

In some cases, service providers compensate by extending the duration of their services for a period equivalent to the downtime. This is also not enough, since the loss incurred by the service provider may be no match for the client's losses (due to a larger business impact).

In industries like ours, even a minimal amount of downtime can cause a severe business impact. So, say if the internet service provider throws in 10 free days for the 10 days of downtime during a certain period, it is of little help to us since such downtime has a significant business impact.

Evaluate your options: You have several choices to consider before you settle for the most suitable service provider. It may seem like vendors have an upper hand, but you must remember that today's market offers several options. Multiple service providers provide similar expertise and services within a single domain.

Not agreeing to be levied by penalty clauses is not necessarily the barometer for a vendor's capabilities. A vendor automatically loses credibility if it repeatedly fails to deliver. For example, an internet service provider's credibility is affected if services are down during a critical operation.

When service providers monitor SLAs, they may try to manipulate uptime numbers. Their frequency of SLA monitoring may not be the initially agreed upon frequency or capture all the information.
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Service providers want to maintain a rapport with their clients, which plays a huge role in determining the service provider's agreed upon penalty clauses.
It's essential to look at building redundancy. You can always engage multiple providers and maintain individual service level agreements (SLA) that factor in penalty clauses. The penalty clause should be limited to what the vendors earn and what it gets out of that order. It cannot go beyond that figure. For example, with a product company you can use penalty clauses which specify that the product is free for your use if it's not delivered within the specified timeline.

Continuously monitor the SLA: Define the overall percentage of uptime and the permissible downtime for a specific period at the beginning itself. Service providers calculate SLAs on an annual, half yearly or quarterly basis. When they monitor the SLA, they may try to manipulate these (uptime) numbers. Their frequency of monitoring the SLA may not be the initially agreed upon frequency or they may not capture complete information.

It is important that you set the metrics. Generally, people closely monitor SLAs only when something goes wrong. Instead, regularly monitor defined metrics using a tool or manual methods.

About the author: Sachin Jain is the CIO of Evalueserve, a leading knowledge process outsourcing (KPO) services firm in India.

(As told to Aishwarya Ramani.)

This was last published in December 2009

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